Up and Down Wall Street

Dr. Frankenstein's Idle Remorse

Former Citigroup CEO Sandy Weill, the man who dismantled Glass-Steagall, now thinks we should bring it back. But that's not the answer. Plus, some good news from the European Central Bank and some not-so-good news from the U.S. Federal Reserve.

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Some years after his monster laid waste to the town, Dr. Frankenstein apparently has reconsidered the wisdom of his creation and has determined it wasn't such a good thing after all.

That's one way to view the conversion of former
Citigroup C -0.23237800154918667%Citigroup Inc.U.S.: NYSEUSD51.52
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23.312217194570135Market Cap
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(ticker: C) chief executive Sandy Weill to the counter-reformation sweeping the financial industry calling for the reinstatement of the Glass-Steagall Act. The irony is rich, almost as rich as Weill himself. After all, it was he who swung the wrecking ball to the Depression-era measure that separated commercial banking from investment banking and insurance.

Indeed, Glass-Steagall was still officially the law of the land when Weill engineered the merger of Citi and Travelers Group in April 1998 for what then was a record-setting $70 billion. The Citi-Travelers deal brought Salomon Smith Barney into fold, combining banking and brokerage in a way that would have had Messrs. Glass and Steagall spinning in their graves. That legal formality was taken care of the following year with the passage of the Gramm-Leach-Bliley Act, which swept away the last vestiges of the moribund Glass-Steagall.

But last week, Weill went on CNBC to declare it was all a mistake. "What we should probably do is go and split up investment banking from banking, have banks be deposit takers, have banks make commercial loans, have banks do something that's not going to risk taxpayer dollars, that's not too big to fail," declared the man who took a second-tier finance company in the mid-1980s and, through a series of acquisitions and roll-ups, created a banking, securities, and insurance behemoth.

Why the change of heart? It's doubtful some of Citi's lowlights of the early 2000s played a role, such as its work with illustrious investment-banking clients Enron and WorldCom. Perhaps it has something to do with Citi's stock-price performance. When Citi and Travelers hooked up in 1998, Citi's stock hit a then-high of $35.63. In 2003, when Weill stepped down as CEO and elevated Chuck ("We're still dancing") Prince, Citi bought back $300 million of Weill's stock at an average price of $47.14.

Citi's shares closed Friday at 27.30, which would imply the stock has lost nearly a quarter of its value since the 1998 merger. Except for one teensy-weensy detail: The stock had a reverse 1-for-10 split last year. Thus adjusted, Bill Gross of Pimco tweeted after Weill's comments, Citi shareholders are down 90% since the merger. Actually, Citi's shares would have to recover to the mid-30s, where they traded in March, which would be about a 30% pop from here. And that's after a 9% surge in the sessions following Weill's video turn, based on the notion Citi and other big banks would be worth more split up.

The repeal of Glass-Steagall is widely blamed for the financial crisis, in that it permitted the creation of too-big-to-fail monstrosities. So reinstating the law passed in the wake of the 1929 crash and subsequent bank failures would seem to make sense, many agree.

Indeed, history shows the too-big-to-fail concept originated in the 1980s, when Continental Illinois had to be rescued. That was a bank that took in deposits and made loans, just as Weill and Glass-Steagall fans say banks should. Yet Continental made bad loans, which have sunk banks for centuries. Ditto the myriad savings and loans whose feckless lending in the late 1980s and early 1990s ended up costing taxpayers some $124 billion.

On that score, Edward Yardeni, who leads Yardeni Research, wrote: "The problem with banks is that they tend to blow up on a regular basis. That's because bankers are playing with other people's money (OPM). They consistently abuse the privilege and shirk their fiduciary responsibilities. Whenever they get into trouble, government regulators scramble to bail them out first and then scramble to regulate them more strictly. Without fail, the bankers respond to tougher rules by using some of the OPM to hire financial engineers and political lobbyists to figure out ways around the new regulations.

"In my opinion, banks are the Achilles' heel of capitalism. They really do need to be regulated like utilities if their liabilities are either explicitly or implicitly guaranteed by the government, i.e., by taxpayers. Banks should be permitted to earn a very low utility-like stable return. Bankers should receive compensation in the middle of the pay scale for government employees, somewhere between the pay of a postal worker and the head of the FDIC. It should be the capital markets, hedge funds, and private-equity investors that provide credit to risky borrowers instead of the banks."

Bankers, you'll be shocked to learn, disagree with that sentiment. And they're being subject to increased regulation with Dodd-Frank and the Volcker Rule, which is supposed to put an end to proprietary trading. Not to worry, however. As Yardeni observes, bankers push back with lobbyists. And given the state of campaign finance, politicians won't be turning away bankers' contributions. The monsters will survive.

All of this faded from memory Thursday morning, when European Central Bank president Mario Draghi declared the bank was "ready to do whatever it takes" preserve the euro. And if anybody didn't get the message, he added for emphasis: "Believe me, it will be enough." What it will be, he isn't saying. We may get a hint Thursday when the ECB holds its policy meeting.

The markets are hoping the ECB will resume its large-scale purchases of bonds of Spain and Italy, to lower those beleaguered governments' borrowing costs, which had been spiraling steadily higher. Spain's benchmark 10-year yield, which hit a record 7.62% at mid-week, ended Friday at 6.77% -- a huge, 85-basis point drop in two days. Italy's 10-year bond yield tumbled 51 basis points, to 5.97%. Those ECB bond buys (which could be done directly or through the back door, as described in Barron's recent cover story, "The Euro's Fate," July 16) would lower yields, expand euro liquidity and continue to lower the common currency.

EQUAL FOCUS WILL BE ON the Federal Reserve, whose policy-setting Open Market Committee winds up its two-day confab Wednesday amid anticipation of further monetary moves to rouse the U.S. economy. Friday brought news that U.S. gross domestic product grew at a tepid 1.5% real annual rate in the second quarter, down from 2.0% in previous quarter.

Fed officials have indicated they're prepared to keep prodding the economy along. But anything they do is likely to be minimal, says Lacy Hunt, chief economist at Hoisington Investment Management. If the central bank injects liquidity, it can't control where that liquidity goes. "It can go into stocks, but unfortunately in this environment, it will likely fan commodity speculation, buoy energy prices and have deleterious inflation effects" he says. "It may benefit Wall Street, but it will harm the great majority of households that are not doing well."

Over the last 12 quarters since the so-called recovery began, real GDP has grown at a 1.6% annual rate, less than half the post-World War II average. It's vastly worse on the income side: Real disposable income has grown at a miniscule 0.2% annual rate, vastly lower than the 2.9% average pace of post-war recoveries. There's a key difference between those gauges. "GDP measures spending while income measures prosperity," Hunt explains. And the latter has been sorely lacking.

There is little monetary policy can do to reverse this doleful trend. There is no lack of liquidity, Hunt says. That's evidenced by banks' hanging onto $1.5 trillion in excess reserves, on which the Fed pays them 0.25% -- more than the public can earn on its cash balances and more than two-year Treasury notes yield. But prodding banks to make more unproductive loans in an economy already beset with excessive debt won't help the economy. "There are no magic elixirs," Hunt concludes.

Editors Note: This column has been revised to remove a reference to Cisco System's earnings report. Cisco shares were down sharply last week owing to concerns about competitive pressures. Cisco is scheduled to report earnings Aug. 15.